Was Selling Ortho-Clinical Diagnostics A Right Move For Johnson & Johnson?

Johnson & Johnson's (NYSE:JNJ) image is undergoing a transformation as its pharmaceuticals business is becoming more significant. The company has traditionally been known for its medical devices and diagnostics equipment, but that is slowly changing. It recently announced the sale of its diagnostics unit, Ortho-Clinical Diagnostics, to Carlyle group for around $4 billion. [1] Ortho-Clinical Diagnostics manufactures and markets donor screening and blood typing products, besides being involved in information management, testing technologies and automation and interpretation tools. A report from Kalorama suggests that the growth prospects for the blood testing market show promise. [2] However, this seems at odds with the performance of J&J's diagnostics unit. The unit's revenues have declined in the last two years, and have also come down as a percentage of total medical devices revenues. This can be attributed to certain inventory issues and pricing pressure due to growing competition. We believe that considering the recent trends and the fact that the company is increasingly diverting its funds toward pharmaceutical research, the sale makes sense.

The annual revenues from J&J's diagnostics business stood at $1.84 billion in 2008 and increased to $2.16 billion by 2011. However, the figure fell in the subsequent years amounting to $1.89 billion in 2013. As a percentage of overall medical devices and diagnostics revenues, Ortho-Clinical Diagnostics sales declined from 8.3% in 2010 to 6.6% in 2013. We estimate the medical devices and the diagnostics business constitutes roughly 60% to J&J's estimated $256 billion value. This pegs the value of this business at around $150 billion. If we were to attribute values to the sub-segments within medical devices and diagnostics in the proportion of their revenues, Ortho-Clinical diagnostics will stand at roughly $10 billion. However, this is not correct because the outlook for this division differs from rest of the segments including vision care, cardiovascular care, orthopaedics, etc.

Assuming that the percentage contribution of ortho-clinical diagnostics in J&J's overall medical devices and diagnostics business continues to decline by roughly 0.9% each year, which has been the case for the last two years, the figure will reach between 2%-3% by 2018. With a discounted cash flow technique, most of the valuation stems from the expected condition of the business a few years down the line. A $4 billion price can only be justified if both J&J and Carlyle group agree that the outlook for the diagnostics unit is as pessimistic as described above, under J&J's umbrella.

As far as J&J is concerned, it can use the cash generated through the sale to fund its research and development and marketing efforts for the pharmaceutical business. This is where most of the company's growth is coming from. This is an opportune time to generate cash to invest in more promising parts of the business.